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CHAPTER I: INTRODUCTION TO FINANCIAL MANAGEMENT

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1. The Goal of the Firm


The goal of the firm is to create value for the

firms legal owners (that is, its shareholders). Thus the goal of the firm is to maximize shareholder wealth by maximizing the price of the existing common stock.

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Why is Shareholder Maximization NOT Profit Maximization?


Many people think the goal is to maximize profits. However, profit maximization goal is unclear about the

time frame over which profits are to be measured. Would this mean short-term profit, or long-term profit?
It is easy to manipulate the profits through various

accounting policies.
Profit maximization goal ignores risk and timing of

cash flows.
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2. Five Foundational Principles of Finance

Cash flow is what matters Money has a time value Risk requires a reward Market prices are generally right Conflicts of interest cause agency problems
while it is not necessary to understand finance in order to understand these principles, it is necessary to understand these principles in order to understand finance.
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Principle 1: Cash flow is what matters


Accounting profits are not equal to cash flows. It is

possible for a firm to generate accounting profits but not have cash or to generate cash flows but not report accounting profits in the books.
Cash flow, and not profits, drive the value of a

business.
We must determine incremental cash flows when

making financial decisions.


Incremental cash flow is the difference between the projected

cash flows if the project is selected, versus what they will be, if the project is not selected.
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Principle 2: Money has a time value


A dollar received today is worth more than a

dollar received in the future.


Since we can earn interest on money received

today, it is better to receive money earlier rather than later.

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Principle 3: Risk requires a Reward


We wont take on additional risk unless we

expect to be compensated with additional reward or return. Investors expect to be compensated for delaying consumption and taking on risk.
Thus investors expect a return when they put their

savings in a bank (i.e. delay consumption) and they expect to earn a higher rate of return on stocks relative to bank savings account (i.e. taking on risk)

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Principle 4: Market Prices are generally Right


In an efficient market, the prices of all traded assets

(such as stocks and bonds) at any instant in time fully reflect all available information. Thus stock prices are a useful indicator of the value of the firm. Prices changes reflect changes in expected future cash flows. Good decisions will tend to increase the stock prices and vice versa. Note there are inefficiencies in the market that may distort the prices.

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Principle 5: Conflicts of interest cause agency problems


The separation of management and the

ownership of the firm creates an agency problem. Managers may make decisions that are not consistent with the goal of maximizing shareholder wealth.
Agency conflict is reduced through monitoring

(ex. Annual reports), compensation schemes (ex. stock options), and market mechanisms (ex. Takeovers)

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Ethics and business


Ethical behavior is doing the right thing!

but what is the right thing?


Ethical dilemma - Each person has his or

her own set of values, which forms the basis for personal judgments about what is the right thing.
Sound ethical standards are important for

business and personal success. Unethical decisions can destroy shareholder wealth (ex. Enron Scandal)All rights 2011 Pearson Prentice Hall.
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3. The Role of Finance in Business


Three broad issues addressed by the study of

finance:
1) Where to Invest? (Capital budgeting decision) 2) How to raise money to fund the investment? (Capital structure decision) 3) How to manage cash flows from daily operations? (Working capital decision)

Knowledge of financial tools is relevant for

decision making in all areas of business (be it marketing, production etc.).


Decisions involve an element of time and
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uncertainty Prentice Hall. All rights tools help adjust for 2011 Pearson financial reserved. time and risk.

The Role of a Financial Manager in a Firm

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4. The Legal Forms of Business Organization


Business Forms

Sole Proprietorship

Partnership

Corporation

Hybrid

S-Type

LLC

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Sole Proprietorship
Business owned by an individual Owner maintains title to assets and profits

Unlimited liability
Termination occurs on owners death or by

owners choice

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Partnerships
Two or more persons come together as co-owners
General Partnership: All partners are fully

responsible for liabilities incurred by the partnership.


Limited Partnerships: One or more partners can

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have limited liability, restricted to the amount of capital invested in the partnership. There must be at least one general partner with unlimited liability. Limited partners cannot participate in the management of the business and their names cannot appear in the name of the firm. 2011 Pearson Prentice Hall. All rights
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Corporation
Legally functions separate and apart from its owners
Corporation can sue, be sued, purchase, sell, and own

property

Owners (shareholders) dictate direction and policies

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of the corporation, oftentimes through elected board of directors. Shareholders liability is restricted to amount of investment in company Life of corporation does not depend on the owners corporation continues to exist through easy transfer of ownership 2011 Pearson Prentice Hall. All rights Taxed separately reserved.

The trade-offs: Corporate Form


Benefits: Limited liability, Easy to transfer

ownership, Easier to raise capital, Unlimited life (unless the firm goes through corporate restructuring such as mergers and bankruptcies)
Drawbacks: No secrecy of information,

maybe delays in decision making, Greater regulation, double taxation.

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WRMAS

5) Financial Markets & Institutions: Transfer of Capital


Financial markets play a critical role in capitalist

economy. Financial markets help facilitate the transfer of funds from saving surplus units to saving deficit units i.e. transfer money from those who have the money to those who need it.
See Figure 2-1 for three ways to transfer capital in the

economy:
Direct transfer Indirect transfer using the investment banker Indirect transfer using a financial intermediary

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Figure 2-1

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Public Offerings Versus Private Placements


Public

Offering Both individuals and institutional investors have the opportunity to purchase securities. The securities are initially sold by the managing investment bank firm. The issuing firm never actually meets the ultimate purchaser of securities.
and sold to a limited number of investors.

Private Placement The securities are offered

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Primary versus secondary markets


Primary Market (initial issue) Market in which new issues of a securities are sold to initial buyers. This is the only time the issuing firm ever gets any money for the securities. Example: Google raised $1.76 billion through sale of shares to public in August 2004. Seasoned Equity Offering: It refers to sale of additional shares by a company whose shares are already publicly traded. Example: Google raised $4.18 billion in September 2005 Secondary Market (subsequent trading) Market in which previously issued securities are traded. The issuing corporation does not get any money for stocks traded on the secondary market. Example: Trading among investors today of Google stocks.
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Money versus Capital Market


Money Market Market for short-term debt instruments (maturity periods of one year or less). Money market is typically a telephone and computer market (rather than a physical building) Examples: Treasury bills (issued by federal government), commercial paper, negotiable CDs, bankers acceptances.
Capital Market Market for long-term financial securities (maturity greater than

one year). Examples: Corporate Bonds, Common stocks, Treasury Bonds, term loans and financial leases.
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